Did Multinationals Use a Foreign Earnings Tax Holiday To Burnish Their Financials Rather Than Reduce Taxes?

We've known for years that the 2004 repatriation tax holiday did little to boost domestic investment or create U.S. jobs, as promised by its backers. Now we are learning that many multinational corporations were not even interested in using the temporary holiday to cut their taxes. Instead, according to a new study, it may have been little more than an easy way for them to manipulate earnings to polish their financial statements.

Yet Congress remains seduced by the idea. After all, it looks free money--a plan that raises revenue but can be promoted as a tax cut. That’s why a decade ago lawmakers enacted a temporary tax break for multinational firms that brought their foreign earnings back to the U.S. And that’s why pols as diverse as Senate Democratic Leader Harry Reid (D-NV) and Senator Rand Paul (R-KY) are pushing for a new version of a repatriation holiday today.

It was a terrible idea back in 2004. It is still a terrible idea—and two very different analyses help explain why.

The first, by the congressional Joint Committee on Taxation, estimates that while cutting taxes for one year on repatriated earnings briefly generates new revenue, it significantly increases the deficit even within Congress’ usual 10-year budget window.

According to a new JCT estimate, such a holiday would boost federal revenues by about $19 billion over the first two years as firms pay some tax on funds they would otherwise have kept overseas tax-free. But since multinationals are getting a tax break for bringing money back they would eventually have returned anyway (at higher rates), JCT figures the tax holiday would add almost $96 billion to the deficit over a decade. So much for free money.

The second study, by financial accounting experts Michaele Morrow of Northeastern University and Robert C. Ricketts of Texas Tech, looks closely at how firms responded to the 2004 tax break. Their fascinating conclusion: For many multinationals, the benefit of the holiday was not primarily tax savings at all. Rather, it provided an easy way to manage the earnings they report to shareholders by manipulating their financial statements.

To put it a bit more crudely: Congress let multinationals pay deeply discounted taxes on $350 billion in repatriated earnings largely to make them look good to Wall Street analysts.

The study, published in The Journal of the American Taxation Association, found that while some multinationals used the tax holiday to boost reported earnings, others took advantage of the tax break to reduce book income, all in an attempt to exactly match analysts’ expectations. Either way, many firms were not interested in maximizing real shareholder wealth by reducing taxes. Rather, they brought back only the amount necessary to hit financial reporting targets.

Morrow and Ricketts were answering a perplexing question: If about $800 billion in foreign earnings was available for repatriation at low tax rates, why did firms bring back only $350 billion?

To find out, they surveyed 596 multinationals that reported pre-tax foreign earnings and found less than 60 percent brought any money back at all, and overall they repatriated only about 44 percent of the amount they could have returned.

Why would a firm pass up a chance to bring money back to the U.S. at a steeply-discounted tax rate?

The authors conclude there were two major reasons. The first, and most obvious, is that multinationals had better investment opportunities overseas, even after factoring in the very low tax on repatriated profits. For those firms, the tax holiday had no effect on either their investment decisions or their tax liability.

The second answer is less apparent to those of us who are not accounting geeks. In the words of Morrow and Ricketts, “firms may have viewed the tax holiday primarily as an opportunity to manage reported…earnings rather than an opportunity to save taxes.”

The good news, I suppose, is that since firms may not have been interested in maximizing tax savings, the revenue loss was not as bad as it might have been. But backers insisted the 2004 tax holiday would boost domestic investment and create new U.S. jobs. Extensive other research has found little or no evidence that either happened.

Add it all up and the 2004 law appears to have gone far off the tracks. Firms didn’t increase domestic investment. They didn’t hire more U.S. workers. Now we learn they didn’t even maximize their tax savings. Instead, in many cases, the tax holiday was mostly an opportunity to burnish their financial statements.

As Congress considers whether to declare another holiday, it should ask itself whether that’s the best use of tax revenue.

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